This journal is written by Simon Ward, Henderson's chief economist. Simon comments on economic and market developments from a monetary perspective. We hope you find the content interesting and welcome comments or questions.

UK monetary trends signal that economic prospects have deteriorated but consensus gloom may have become exaggerated again.

Economists now expect the preliminary second-quarter GDP release on 26 July to report quarterly growth of only 0.2-0.3%. This partly reflects weak industrial and construction output data for May – the average levels of output in April / May were 0.5% and 1.6% respectively below their first-quarter averages.

Services output in April, however, was 0.4% above the first-quarter average and turnover data – ignored by most economists – suggest a respectable monthly increase in May. The official GDP estimate is likely to incorporate a projection of further growth in June. Services output, therefore, may be reported to have risen by 0.6% last quarter. With the sector accounting for 79% of GDP, this would suggest overall growth of 0.4% despite industrial / construction weakness – in line with the Bank of England staff’s estimate at the time of the June MPC meeting.

Gloom about consumer spending prospects was magnified by news of a fall in the household saving ratio to a record low. As previously discussed, however, the official saving ratio measure is at odds with other data indicating respectable household accumulation of financial and capital assets.

The official approach measures saving as the difference between disposable income and consumption. An alternative approach is to measure it as new investment in financial and capital assets minus borrowing. Based on the alternative approach, the saving ratio was 7.2% in the year to the first quarter versus only 4.2% for the official measure – see first chart.

The two measures are conceptually equivalent so the difference must reflect measurement error. One possibility is that the official statistics understate income, perhaps reflecting the increasing difficulty of tracking compensation as working patterns change.

According to the official data, household real disposable income fell by 1.4% in the year to the first quarter. The June EU Commission consumer survey, by contrast, reported that a balance of only 2.3% of households judged their finances to have deteriorated over the past 12 months – significantly better than the long-run average (since 1990) of 8.5%.

Pessimistic forecasters argue that a consumer slowdown will be compounded by weakness in business investment. Real* disposable income of private non-financial corporations (PNFCs), however, rose by 20.6% in the year to the first quarter, following a decline in late 2015 / early 2016 – second chart. This pick-up accords with recent stronger corporate money trends, suggesting that a first-quarter recovery in investment will be sustained.

Global monetary trends suggest that economic growth will slow over the summer / autumn before strengthening again in late 2017. Major central banks are likely to proceed with plans for stimulus withdrawal despite weaker near-term momentum, reflecting concern about stretched labour markets. Stronger growth later in 2017 may accelerate policy tightening. Equity markets are at risk from earnings disappointments and / or rising rates. Relative money trends suggest adding US and Japanese exposure at the expense of Europe and emerging markets.

Previous commentaries argued that global economic momentum would slow from a peak in spring 2017. Recent news is consistent with this forecast. Six-month growth of industrial output in the G7 developed economies and seven large emerging economies (the “E7”) reached a three-year high in April before falling in May. J P Morgan’s global manufacturing purchasing managers’ index has eased back from a February / March peak. Citigroup’s G10 economic surprise index, meanwhile, turned negative in June, having been strongly positive earlier in 2017.

The basis for the forecast was a fall in G7 plus E7 real narrow money* growth from a peak in August 2016 – monetary trends lead the economy by about nine months on average. The decline was exaggerated by India’s “demonetisation” programme but an adjusted** real money growth measure also declined significantly – see first chart. The slowdown signal from monetary trends was subsequently confirmed by a shorter-term global leading indicator derived from the OECD’s country leading indicators – second chart.

Adjusted real narrow money growth, however, reached a low in February 2017, recovering solidly through May. Allowing for the average nine-month lead, this suggests a revival in economic momentum in late 2017 / early 2018. Confidence in such a scenario will increase if growth of the leading indicator bottoms out over the summer – its average lead time is about four months, i.e. turning points typically lag those for real money by about five months.

The suggested economic scenario is potentially negative for equity markets. Slower near-term growth would probably be associated with earnings undershooting forecasts – the MSCI All-Country World revisions ratio, indeed, turned negative in June, following a seven-month positive run. Major central banks, however, are focused on inflationary risks from stretched labour markets and would be likely to play down a modest weakening of activity data. The G7 unemployment rate fell to 5.1% in May, the lowest since 1980. A growth revival in late 2017, meanwhile, could trigger faster policy tightening.

The third chart shows that a rebound in US real money growth has been a key driver of the rise in the global measure. Canadian and Japanese trends have also improved, while Chinese growth has stabilised after a significant decline.

Why has US money growth recovered despite Fed rate hikes? One explanation relates to a change in money market fund regulations in 2016. The immediate impact of this change was to encourage a switch in the assets of money funds out of bank deposits and commercial paper into Treasury securities. This shift pushed up banks’ funding costs, with a negative effect on lending and money growth. The three-month LIBOR / Treasury bill yield spread rose from 24 bp in November 2015 to a peak of 55 bp in September 2016.

The portfolio shift, however, appears to have been completed by late 2016. The LIBOR / T bill spread was back at 25 bp in June 2017. Easier funding conditions may have offset the negative impact on money / credit trends of Fed policy tightening. Bank lending as well as narrow money has picked up since early 2017. This explanation suggests that the regulatory change was a headwind for the economy and policy rates in 2016 but is now acting as a tailwind.

Chinese economic growth may hold up during the second half despite recent softer money / credit trends. Real money growth remains at a respectable level – third chart. The earlier monetary surge was reflected in a pick-up in inflationary pressures rather than a significantly stronger economy – fourth chart. The monetary slowdown, similarly, appears to be mainly affecting price momentum – producer prices have stabilised after surging in late 2016 / early 2017. Falling inflation gives the PBoC scope to reverse recent policy tightening to support growth, if necessary.

Strong Euroland business surveys have encouraged hopes that economic growth is ratcheting higher. Monetary trends, however, remain stable, suggesting that GDP will expand at around its recent pace (1.9% in the year to the first quarter of 2017). Surveys may have been boosted by a temporary “Macron effect”. Unemployment continues to fall rapidly and is on course to reach estimates of the “equilibrium” rate in 2018. The Fed was wrapping up QE at the equivalent US stage in 2014. The ECB may accelerate plans for stimulus withdrawal during the second half.

Recent rises in US and Japanese real money growth, coupled with possibly excessive optimism about Euroland economic prospects and weak UK money trends, suggest increasing US / Japanese equity market exposure at the expense of Europe. The US, in addition, would probably outperform in a general pull-back, while official buying might support Japanese stocks. The BoJ remains the most dovish of the major central banks, though may be forced to lift the zero yield cap during the second half if global yields climb.

Real money growth in the E7 emerging economies moved above the G7 level in late 2015, arguing that relative economic and equity market prospects were improving. Adjusted for the Indian demonetisation distortion, the E7 / G7 gap remained positive until recently – fifth chart. Emerging market equities could struggle in a market pull-back or if a stronger US economy forces the Fed to accelerate tightening, a scenario that would probably be associated with upward pressure on the US dollar.

UK corporate money growth has rebounded, suggesting a pick-up in business investment, which Bank of England Governor Mark Carney has cited as a condition for a rise in interest rates. The money numbers, indeed, may have contributed to the change of tone in Governor Carney’s latest speech: the Bank’s suite of forecasting models includes an investment relationship with corporate money and lending.

The first chart shows annual growth rates of nominal GDP and narrow / broad money, as measured by non-financial M1 / M4. The non-financial aggregates cover money holdings of households and private non-financial corporations (PNFCs), omitting financial sector deposits, which are volatile and largely unrelated to economic activity. Annual non-financial M1 growth peaked at 10.1% in September 2016 and fell further to 7.7% in May. Non-financial M4 growth has declined from 6.8% to 5.0% over the same period.

Turning points in annual non-financial M1 growth have consistently led those in nominal GDP growth in recent years. The latter may have peaked in the fourth quarter of 2016 and is likely to move lower during the second half of 2017.

The second chart shows the recent divergence of household and corporate (PNFC) money growth. Annual growth of PNFC M4 has risen from a low of 3.8% in November 2016 to 9.3% in May, a 14-month high. PNFC M1 growth has also rebounded.

Annual household M4 growth, by contrast, has dropped from 6.8% to 3.8% since September 2016. M1 growth has fallen by more.

Economic activity prospects are related more closely to real than nominal monetary trends. The third chart shows two-quarter / six-month changes in GDP and non-financial M1 deflated by consumer prices (seasonally adjusted), along with the household / corporate breakdown of the latter. (Narrow money outperforms broad money for forecasting purposes.) Real non-financial M1 growth has fallen significantly but stabilised in May and remains comfortably above zero, consistent with weak GDP expansion rather than stagnation or contraction.

Two additional considerations caution against gloom. First, corporate real money growth often leads the aggregate measure, suggesting a recovery in the latter. Secondly, the real money slowdown has been driven roughly equally by a fall in nominal money growth and a rise in inflation – consumer prices surged at an annualised rate of 3.8% in the six months to May. Annual inflation is likely to increase further but the six-month rate of change of prices may slow during the second half, supporting real money expansion.

Six-month growth rates of Euroland real (i.e. inflation-adjusted) narrow and broad money declined in April / May but are in the middle of their ranges over the past three years, suggesting future GDP expansion of around the average over this period, i.e. a little under 2% annualised. This would be below expectations based on recent strong business surveys but in line with the ECB’s forecast, supporting plans to wind down policy stimulus later in 2017.

Six-month growth of real narrow money, as measured by non-financial M1 deflated by consumer prices, was 4.0% (not annualised) in May, down from a recent peak of 4.5% in March and slightly below a three-year average of 4.3% (i.e. from May 2014 to April 2017). Growth of real non-financial M3 was 1.8% versus 2.3% in March and a three-year average of 2.1% – see first chart.

Both measures are lower than a year ago, suggesting that GDP momentum is at or close to a peak. GDP rose by 1.1%, or 2.2% annualised, in the fourth and first quarters combined. With the real money growth measures close to their three-year averages, GDP expansion may fall back to around its three-year mean of 1.8% annualised.

The compiler of the purchasing managers’ surveys claims that the average level of the composite output index in the second quarter is consistent with quarterly GDP growth of 0.7%, or 2.8% annualised. The suspicion here is that surveys are overestimating current strength and will realign with the monetary signal – the PMI output index, indeed, declined in June.

The fall in the real money growth measures in April / May reflected a larger decline in nominal expansion partially offset by a slowdown in consumer prices following a surge in late 2016 / early 2017 – second chart.

The non-financial money measures cover holdings of households and non-financial corporations. The official M1 and M3 aggregates also include deposits held by non-bank financial corporations – such deposits are volatile with fluctuations largely unrelated to economic prospects. Growth of real M1 and M3 was lower than that of real non-financial M1 and M3 during 2016, i.e. the official measures underpredicted economic strength – see third chart. The measures have converged recently.

Some monetary economists claim that ECB QE drove money growth higher, laying the foundation for recent solid economic performance. As the charts show, narrow and broad money accelerated strongly in mid-2014, well ahead of the start of QE in March 2015. The view here is that interest rate cuts and ECB lending programmes were more powerful drivers than QE.

Mirroring the experience elsewhere, the direct boost to broad money from QE has been largely offset by a deterioration in the balance of payments basic balance (i.e. much of the liquidity created has been exported) and by commercial banks shifting from buying government bonds to selling them (because the increase in their reserve holdings at the ECB due to QE has reduced their demand for safe liquid securities). The 12-month sum of the contributions of the ECB’s “public sector purchase programme” (PSPP), external banking flows and commercial bank transactions in government securities to the change in broad money M3 has risen by only €80 billion since end-2014, equivalent to a 0.7 percentage point addition to annual M3 growth (i.e. small) – fourth chart.

QE wind-down, by extension, may exert only a limited drag on monetary trends.

June flash PMIs released last week were mostly weaker than expected. In particular, the Euroland composite output index fell to a five-month low, with a slowdown in services activity outweighing further manufacturing strength.

Company earnings news is turning less favourable. The MSCI All-Country World Index earnings revisions ratio fell below zero in June, i.e. downgrades to company earnings forecasts outnumbered upgrades (adjusted for seasonal variation) – see first chart.

Six-month growth of world steel output, meanwhile, dropped sharply in May, suggesting that growth of industrial output peaked in April – second chart.

Improving US prospects

This view is based on a rebound in six-month real narrow money growth since February.

The two-year swap spread correlates inversely with future GDP growth and has fallen since March, consistent with the positive monetary signal – third chart.

A sharp rise in mortgage rates in late 2016 has acted as a drag on housing demand and construction. The rise has partially reversed, suggesting that the drag will lift from late 2017 – fourth chart.

Supportive Chinese monetary conditions

Interpreting current money and credit trends is not straightforward. Annual growth of domestic bank credit has nearly halved since the start of 2016 but this mainly reflects a slowdown in lending to the government and financial sectors; growth of “total social financing” of households and non-financial enterprises, representing “real economy” fund-raising, has been broadly stable – fifth chart.

Annual narrow money growth, meanwhile, has moderated but remains much higher than in 2014-15. The provisional conclusion here is that the authorities have succeeded in reining in speculative credit while avoiding a money / lending squeeze on economic growth.

Optimism about economic prospects has increased but monetary trends suggest stable growth. Surveys may have been boosted by a temporary “Macron effect”, while the global backdrop is turning less favourable.

The Euroland earnings revisions ratio was positive and above the US ratio through May but both turned negative in June – seventh chart.

The Citigroup Euroland economic surprise index has fallen sharply and is expected here to turn negative over the summer, converging with a recovering US index – eighth chart.

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